This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

Equity-Based and Nonqualified Deferred Compensation Plans

Under a
restricted stock plan, an employee is issued
stock subject to a substantial risk of
forfeiture. When the stock is no longer
subject to a risk of forfeiture, the employee
has income in the amount of the fair market
value of the stock less any amount paid for it
by the employee.

Under stock option plans, an employee is
issued stock options to purchase stock that
may be subject to a substantial risk of
forfeiture. The tax treatment of the plan
further depends on whether the plan is
statutory or nonstatutory.

Under a nonqualified deferred compensation
arrangement (DCA), the employee does not
receive an equity interest in the company;
instead, the employer and employee or
independent contractor have a contractual
arrangement under which the person agrees to
be compensated in cash (or much less
frequently in property) in the future for
services the person is providing currently.
There are a number of forms of DCAs.

The rules under Sec. 409A potentially
affect every nonqualified arrangement that
defers the receipt (and taxation) of
compensation income.

This article provides an overview of the federal
income taxation rules governing equity-based
compensation plans as well as nonqualified deferred
compensation plans. Publicly traded companies and
privately held firms frequently use these plans to
enhance the overall compensation packages of higher-end
management. The advent of Sec. 409A has added further
complexity to the myriad tax laws governing such
arrangements.

Actual Stock and Stock Option
Plans

Restricted Stock

Under
a restricted stock plan, the corporate employer
currently issues actual shares of stock to a key
management employee. The employee usually pays nothing
for the stock. The fair market value (FMV) of the stock
in excess of any amount paid by the employee (the
bargain element) will be ordinary income to the
employee.1 The inclusion of this income
occurs at such time as the stock is transferable or is
no longer subject to a substantial risk of forfeiture
(the vesting date).2 A substantial risk of
forfeiture normally requires ongoing full-time
employment through the vesting date.3

An exception to this
general rule occurs if the employee makes a Sec. 83(b)
election. Such an election triggers the taxable event
upon issuance of the nonvested stock and does not
require a subsequent inclusion in income when the risk
of forfeiture lapses in a future tax year. The Sec.
83(b) election is frequently referred to as a “gambler’s
choice” because if the stock is subsequently forfeited,
the employee will receive no deduction that would offset
the earlier inclusion in income on having made the Sec.
83(b) election. This election is usually advisable in
situations where the stock has a relatively low FMV on
issuance but there is a high expectation that it will
substantially rise in value in the future (e.g., a
high-tech startup company).

In either situation,
the employee’s tax basis in the restricted stock
normally is measured by the amount of ordinary income
the employee reports on the occurrence of the taxable
event (a tax-cost basis under Sec. 1012). The employer
would have a corresponding compensation deduction for
federal income tax purposes when the employee recognizes
income regardless of the employer’s tax accounting
method.4

Example 1:P Inc., a publicly
traded corporation, has seen its per share common stock
value fall from $40 to $10 as a result of the general
economic downturn. P’s board of
directors and its management team believe the firm will
triple in value in the next two to three years. In an
attempt to motivate management to attain that goal, the
board authorizes the issuance of a number of shares of
restricted stock to management, who will pay nothing for
the shares. The stock has a two-year vesting period and
is considered to have a substantial risk of forfeiture
because the company requires the employees to remain
full-time employees of P for two years after
the restricted stock is issued. At the time P issues the
restricted stock, it is trading at $10 per share.

Employee A
decides to take the gambler’s choice and makes a Sec.
83(b) election. A files the requisite
form with the IRS and as a result has to include $10 per
share in his ordinary W-2 wage income for the current
year. That year he also establishes a $10 tax-cost basis
per share in the stock. P will take a $10 per
share compensation deduction the same year that A picks up the $10
per share of income. A remains a full-time
employee of P
for the required two-year vesting period, at which time
the stock is worth $30 per share. At this time, the $20
of appreciation that occurred from the time A received the stock
until its vesting date would not be included in his
income until A
disposed of the stock. Also, it should be noted that
P would not
be entitled to any additional compensation
deduction.

When A sells the stock,
his gain will be measured by the tax basis established
by Sec. 1012 when the Sec. 83(b) election was made and
the FMV of the amount realized on the sale, with the
resulting gain being taxed at favorable long-term
capital gain rates. If A terminates
employment prior to the two-year vesting date, he will
forfeit the stock back to P and will have no
tax deduction despite the fact that he previously
reported the $10 per share received as ordinary
income.

At the same time, employee B receives the same
P stock and
does not make the Sec. 83(b) election. She remains a
full-time employee of P for the requisite
two-year vesting period, at which time the stock is
worth $30 per share. In the year of vesting, B has to report $30
per share as ordinary income and has a $30 per share
tax-cost basis in the stock. P has a $30 per share
compensation deduction in the year of vesting. However,
if B terminates
employment with P prior to the
two-year vesting period, she will forfeit her shares
back to P and
will have no income inclusion or tax deduction.

Nonqualified Stock Options

A
nonqualified stock option (NQSO) arrangement is a highly
flexible method of giving an employee (or independent
contractor) an opportunity to purchase employer stock.
This variety of options is labeled nonqualified to
distinguish them from the more employee-favorable
incentive stock options, described below, which are
often known as qualified options. Most stock options are
nonqualified. To the extent that the employer does not
have publicly traded options substantially similar to
those granted under an NQSO, the grant of an option does
not create a taxable event.5 Because of the Sec. 409A
rules discussed below, it will be a rare NQSO that sets
the exercise price at a number less than the FMV of the
underlying stock as of the option grant date. Upon
exercise and purchase of the underlying stock, the
difference between the stock’s FMV and the exercise
price is ordinary wage income to the employee.6

Absent a Sec. 83(b)
election, to the extent that the stock received on
exercise is subject to a substantial risk of forfeiture,
the stock is not immediately taxable as noted above
under the restricted stock discussion. In that case, the
resulting wage income will not be taxable until that
forfeiture condition lapses, at which time the stock’s
FMV in excess of the exercise price will be included in
the employee’s wage income. As also noted above, the
employer will have a corresponding compensation
deduction for federal income tax purposes equal to the
amount of the employee’s income inclusion in the year
the employee recognizes income.

Because the
optionee has to come up with sufficient after-tax cash
to pay the exercise price and cover the taxable event
related to the exercise, cashflow becomes a problem.
Therefore, as noted below, stock appreciation rights
(which allow for a cash payment) are frequently coupled
with nonqualified options.

Incentive Stock Options

Incentive
stock options (ISOs) are frequently more desirable from
the employee’s standpoint (independent contractors
cannot participate in an ISO arrangement).7 As noted above, ISOs
frequently are referred to as qualified options to
distinguish them from nonqualified options. On grant of
the option, the exercise price must be no lower than the
underlying stock’s FMV.8 Upon exercise, the employee
must come up with the exercise price in after-tax
dollars (as with the NQSO) but suffers no regular income
tax liability.9 The bargain element (the
difference between the stock’s FMV and the exercise
price) may trigger alternative minimum tax (AMT)
liability as it is frequently a substantial positive AMT
adjustment.10

The lack of a regular taxable event
better assures the optionee that he or she will be able
to retain the stock after exercise because there will be
no regular tax liability to contend with at that time.
Upon selling the stock at a profit at a later point in
time (no earlier than two years from the date of grant
or within one year after the exercise of the option),
the employee will obtain long-term capital gain
treatment.11 Otherwise the sale will be
a disqualified disposition that will generate ordinary
income.12

Even though the tax
results are much better for the option holder, the
employer will have no compensation deduction under an
ISO. Another negative aspect is that an employer may
grant no more than $100,000 worth of ISOs to an employee
in any year, thus limiting it as a compensatory tool for
very highly compensated employees (HCEs).13

Example 2: Employer R Inc. grants an NQSO
to employee C,
entitling him to purchase R shares at $10 per
share, the current price of the stock, over the next two
years. R
simultaneously grants an ISO to employee D, entitling her to
buy R shares at
$10 per share over a two-year period. A year later the
stock has risen to $20 per share, and C and D both exercise their
options in full, receiving stock not subject to a risk
of forfeiture. C
recognizes $10 per share of ordinary wage income
at that time, and R is entitled to a
$10 per share compensation deduction. In contrast, D does not recognize
any regular income at the time of exercise, and R will have no
deduction.

Subsequent appreciation in R stock will be
treated as a capital gain to either C or D on disposition of
the stock, assuming they hold the stock at least a full
additional year. C’s tax basis will be
$20 per share (the $10 per share paid on exercise and
the $10 per share recognized as ordinary income when the
option was exercised), and D’s tax basis will be
$10 per share (the $10 per share paid on exercise).

Nonqualified Deferred Compensation Arrangements

General Features

A nonqualified
deferred compensation arrangement (DCA) does not involve
equity ownership in the employer; instead, it is a
contractual arrangement under which an employee or
independent contractor agrees to be compensated (usually
in cash) in a future year for services currently being
rendered. The structure of a DCA can be very flexible.
Apart from the Sec. 409A restrictions discussed below,
the only major restrictions are that the arrangement not
be formally funded (to avoid tax problems under Sec.
83(a)) and that the DCA participants be limited to
management or HCEs in order to avoid Employee Retirement
Income Security Act (ERISA) problems.14 A so-called rabbi trust
(discussed below) does not violate the no formal funding
requirement and does provide participants with some
enhanced assurance that their benefits will be paid
except in cases of the employer’s legal insolvency or
bankruptcy.

Payments under a DCA usually start when
the employment ends (e.g., upon retirement) or upon
pre-retirement death or disability. There are two broad
structural categories of DCAs: elective and nonelective.
Under an elective DCA, the employee agrees to receive
less salary and bonus compensation than he or she would
otherwise currently receive and to defer receipt of the
reduced amount to a future tax year. The point here is
that the employee initiates the deferral. The election
to defer income must be made prior to the time in which
the income is earned (e.g., a salary reduction agreement
to defer 10% of compensation that would otherwise be
earned and payable in the 2012 calendar year must be
entered into on or before December 31, 2011).15

Because under an
elective DCA the employee initiates deferral of
compensation that he or she would otherwise shortly earn
and receive, imposing a substantial risk of forfeiture
on the DCA benefits would be inappropriate. As noted
above, a substantial risk of forfeiture is a vesting
mechanism requiring substantial future services before
benefits become nonforfeitable. Therefore, an elective
deferral will typically be fully vested and payable in
the event of termination of employment for virtually any
reason.

Nonelective deferred compensation is a
different type of contractual arrangement. It is not
unusual for larger employers to provide a deferred
compensation benefit as a pure add-on fringe benefit to
key employees. It does not result in a reduction in
their current salary or bonus compensation otherwise
payable. This is the so-called velvet handcuff mechanism
for retaining key employees, and it usually incorporates
a substantial risk of forfeiture requiring a number of
years of service before the benefits become
nonforfeitable.

In both elective and nonelective
DCAs, the employee’s taxable event typically is deferred
until the employee receives the DCA benefits in the
future,16 and the employer’s
deduction is deferred until the tax year in which the
employee recognizes the deferred compensation.17 All the arrangements
described below are of the nonelective variety.

The Sec. 409A rules are discussed following the
description of these forms of nonqualified DCAs.

Stock Appreciation Rights

A stock
appreciation right (SAR) is a form of nonqualified
deferred compensation (NQDC) that frequently is coupled
with an NQSO plan and sometimes with an ISO plan. The
SAR will pay a benefit linked to the appreciation in
value of the employer’s stock after issuance of the SAR.
The purpose of the SAR often is to provide a
contemporaneous cash payment to the optionee when he or
she exercises a stock option. The SAR thus provides cash
to the NQSO holder to cover both exercise price and tax
liability while providing the ISO holder with cash to
accommodate the exercise price (and perhaps AMT
liability). As long as the SAR is issued only to key
management and HCEs, there will be minimal ERISA issues
(the other arrangements discussed herein can also be
provided on a completely discriminatory basis for the
sole benefit of HCEs and, indeed, must be in order to
avoid ERISA entanglements). The SAR cash benefits are
ordinary wage income taxable to the employee on receipt
of the cash on exercise and generate a compensation
deduction to the employer in the same tax year as the
employee recognizes the income.

Phantom Stock Plans

A phantom stock
plan is another form of DCA in which there is a deferred
cash benefit but no actual stock ownership. Conceptually
similar to the SAR but not linked to a stock option
plan, the amount of the benefit is generally measured by
appreciation in the value of the employer’s stock from
the inception of the arrangement. As with any DCA,
ordinary income is taxable to the employee on receipt,
and the employer gets a compensation deduction in that
same tax year.

In terms of participation, the
board of directors commonly provides new phantom stock
grants each year or two based on past performance. Thus,
the level of participation will be based on past
performance and merit, yet the future benefit value will
still be a function of future appreciation, thereby
providing the desired incentive to management.

Performance Unit Plan

Like the
phantom stock plan, this DCA pays a deferred cash
benefit based on company performance. Here, however, the
benefit is not linked to the value of employer stock but
to some other measurement such as increase in earnings
per share or stockholder equity. As we have seen with
the other variations of deferred compensation, income is
taxable to the employee on receipt of the cash benefit,
and a corresponding compensation deduction is then
available to the employer.

SERPs

A supplemental employee
retirement plan (SERP) is another form of nonelective
deferred compensation. It makes up for benefits lost by
HCEs under the employer’s qualified retirement plans.
Due to Sec. 415(c)(3), which imposes benefit accrual
restrictions for highly compensated participants, only a
limited amount of the employee’s annual compensation can
be considered for purposes of accruing qualified plan
benefits ($245,000 for 2011).18
This is a very common form of NQDC.

Other DCAs

Within the constraints
mentioned above relative to elective and nonelective
DCAs, there are a number of additional possibilities for
structuring plans. One key point mentioned earlier is
the HCE requirement. All the above DCA arrangements must
be HCE plans in order to avoid troublesome ERISA
requirements. Therefore, all plan participants must
objectively be highly compensated and management class
employees relative to nonparticipants.

Example 3: E is a highly
compensated executive of S, Inc. S has a qualified
profit-sharing plan (a qualified plan) in place for all
its employees who work 1,000 hours or more a year
(including E).
Under that plan, S
generally makes an annual contribution of 10% of
each participating employee’s compensation for the year.
E’s
compensation for the year is $500,000. Because Sec.
401(a)(17) limits the amount of compensation that can be
considered for annual benefit accrual purposes to
$245,000 in 2011, S
is precluded from making a profit-sharing
contribution for the majority of E’s compensation.
However, S does
maintain a SERP for E
and similar executives whose profit-sharing
contributions are affected by Sec. 415.

In 2011,
S credits
E’s SERP
account by $25,500 ($255,000 not considered compensation
under the profit-sharing plan × the 10% factor). S does not actually
contribute any wealth to an account in which E has a legal
interest. As a SERP participant, E has only S’s contractual
promise to pay the benefit in the future as called for
under the contract. As discussed above, to the extent
that E has a
legal interest in any formal funding vehicle such as a
trust or escrow account (as opposed to an informal
funding vehicle such as the rabbi trust discussed
below), Sec. 83 will accelerate the taxable event.

E’s benefit
under the SERP will commence only on his separation from
service because of retirement, death, or disability,
which are permissible triggering events under Sec. 409A.
There is also a substantial risk of forfeiture
associated with the benefit that requires E to continue in
the full-time employment of S for at least 10
years from the commencement of his participation in the
SERP. At that point in time, he will have a vested
benefit in his deferred compensation, and the income
taxation of the benefits will be deferred until E actually receives
them on separation from service.

Because all
participants under the SERP are highly compensated
management of S
(all HCEs), the SERP need not comply with the
eligibility, participation, funding, and reporting and
disclosure requirements normally required of an ERISA
pension plan.

Sec. 409A Deferred Compensation
Rules

Overview

Sec. 409A is
generally applicable to compensation deferred under a
DCA (which definition would apply to all the DCAs noted
above) after December 31, 2004.19 The rules under Sec. 409A
potentially affect every nonqualified arrangement that
defers the receipt (and taxation) of compensation
income. For purposes of the rules, a Sec. 409A deferral
includes any individualized arrangement such as an
employment agreement or a more formal plan covering
multiple HCEs that provides for deferral of compensation
from the year in which the employee earns it into a
future tax year.20

The Sec. 409A DCA definition does not
include qualified retirement plans (e.g., a
tax-qualified pension, a profit-sharing plan, a Sec.
401(k) plan, a Sec. 403(b) tax-deferred annuity, and a
Sec. 457(b) eligible plan for state, government, or
tax-exempt employees)21 or bona fide vacation,
sick leave, disability pay, or death benefit plans.22 Also excluded from the
definition of a Sec. 409A deferral are so-called
short-term deferrals, welfare benefit plans, and certain
involuntary severance pay arrangements.23 Certain equity incentive
plans, such as the NQSO and SAR arrangements discussed
above, could be DCAs if the exercise or measuring price
is less than the FMV of the underlying stock on the date
of grant24 (see the Sec. 409A
discussion of stock options below).

Sec. 409A
imposes a tax acceleration and significant penalty to
the extent that the DCA experiences a “plan failure”
(described below), and the plan benefits to be paid in
the future are not then subject to a substantial risk of
forfeiture. As already noted, a contractual requirement
to render substantial future services before vesting the
benefit is a substantial risk of forfeiture. Upon a plan
failure, absent an ongoing substantial risk of
forfeiture, not only will all deferred compensation
(plus any earnings attributable to it) be accelerated
into income, but a 20% penalty tax and interest will be
imposed that year.25

Early
Distribution

Plan failures under the rules can
take a variety of forms. The first would result from an
improper early distribution under the DCA. An improper
early distribution would occur if the plan could pay
benefits prior to:

The date of the
participating employee’s separation from service or
before that participant became disabled or died;26

The time
initially specified in the plan for payout;

The time of a change in the ownership or effective
control of the employer; or

Subsequent Deferral

A plan failure
also includes an ability to again defer payments
scheduled to be made under the original terms of the
DCA. The plan may permit subsequent elections to delay
or change the form of payments if the new election
cannot take effect until at least 12 months after it is
made. In addition, a more typical election to further
defer a distribution due to be made after the
participant’s separation from service, upon a
predetermined date or schedule or upon a change in
ownership of the employer, must defer the delayed
payment for at least an additional five years.28 Therefore, benefits
originally scheduled to commence on separation from
service can again be deferred if they will not commence
for five years after the separation.

Initial Deferral Election

Another
major category of plan failure relates to the initial
deferral election for elective DCAs (in which the
employee initiates the deferral decision). Sec. 409A
codifies the IRS’s prior position in Rev. Proc.
71-1929 by requiring that a
participant’s election for deferral is effective only if
the participant makes it before the tax year in which he
or she will earn the deferred compensation. If the
deferred compensation is based on performance criteria
or services performed over a period of at least 12
months (e.g., bonus compensation), the election must be
made no later than 6 months before the end of the
measurement period. With regard to a new participant
(for example, a new officer hired during the plan year),
the new participant must make the election within 30
days after the date he or she becomes eligible to
participate in the DCA.30

Funding
Arrangements

Long before the advent of Sec. 409A,
formally funding an NQDC obligation accelerated the
taxable event to the participating employee.31
To the extent that the participant had a
vested, nonforfeitable interest in any trusteed money (a
secular trust) to be used to satisfy DCA payments,
taxation on the deferred compensation was, and still is,
accelerated.

An important and frequently used
device to somewhat increase the likelihood that deferred
compensation will be paid without accelerating the
taxable event is through “informal” funding of the
obligation in a rabbi trust. In a rabbi trust, the
employer irrevocably contributes money to a trust to
satisfy the deferred compensation obligations, yet that
money remains subject to the employer’s general and
secured creditors in the event of legal insolvency or
bankruptcy. Because of this contingency, the IRS has
long acknowledged that employee taxation is not
accelerated by funding deferred compensation obligations
in a rabbi trust.32

Sec. 409A does not
change this result, except in the rarest situations.
Under the Sec. 409A rules, employee taxation through the
use of a rabbi trust is accelerated only if the trust is
an offshore trust (thus providing a practical impediment
to employer creditors reaching the trust assets) or if
it is a “springing” arrangement under which the rabbi
trust would be substantially funded (or a preexisting
rabbi trust would contractually flip to secular
trust33 status) upon a negative
change in the employer’s financial health short of legal
insolvency or bankruptcy.34

Stock
Options

An option to purchase stock that is a
nonstatutory stock option may be deemed to be a DCA
subject to Sec. 409A. More specifically, a nonstatutory
stock option is one other than an incentive (qualified)
stock option described in Sec. 422 (the ISO discussed
above) or an option granted under a qualified employee
stock purchase plan as provided in Sec. 423. Therefore,
the NQSOs described earlier will constitute nonstatutory
stock options as defined under the new law.35 Such a nonstatutory stock
option will further constitute a Sec. 409A DCA if the
amount required to purchase stock under the option is
less than the FMV of the underlying stock on the date
the option is granted (a fairly rare event even before
Sec. 409A).36

Conclusion

It is incumbent on the business and the tax adviser
to scrutinize any arrangement (regardless of how
labeled) for deferrals of income beyond the year in
which they are earned by the benefited employee. To the
extent that such deferrals are not specifically excepted
from the Sec. 409A rules (qualified pensions, short-term
deferrals, welfare benefit plans, involuntary severance
pay arrangements), it is likely that such arrangements
are subject to Sec. 409A. The tax adviser must also look
for such Sec. 409A deferrals in other contractual
arrangements to purchase or receive equity in the
employer. The adviser must then ensure that such equity
compensation plans are accounted for under older tax law
(discussed in the section above on actual stock and
stock option plans) as well as Sec. 409A.

26 A disability is defined
as a mental or physical impairment that is expected to
last for more than a year and (1) prevents the employee
from engaging in substantial gainful activity or (2) is
one for which the employee is receiving disability
income benefits for a period of not less than three
months under an employer disability plan (Sec.
409A(a)(2)(c)).

27 An unforeseen emergency
is a severe financial hardship to the participating
employee resulting from an illness or accident to the
participant, the participant’s spouse, or a dependent of
the participant not compensated or reimbursed through
insurance or otherwise. Such an emergency also includes
a loss of the participant’s property due to casualty or
a similar extraordinary and unforeseeable circumstance
(Sec. 409A(a)(2)(B)(ii)).

Mark Altieri is an associate professor at Kent State
University in Kent, OH, and special tax counsel to
Wickens, Herzer, Panza, Cook, and Batista Co. in Avon,
OH. For more information about this article, contact
Prof. Altieri at maltieri@kent.edu.

Among CPA tax preparers, tax return preparation software generates often extensive and ardent discussion. To get through the rigors of tax season, they depend on their tax preparation software. Here’s how they rate the leading professional products.

Don’t get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. Tax Section membership will help you stay up to date and make your practice more efficient.